What you should know about Interest Rates

To be street smart about money, and increase your success in handling it, you must know what the components of interest rates are. First of all, interest is nothing more than “rent on money.” If you’re going to borrow money, you’re going to pay some type of “rent” on that money to borrow it. The key is, you want to pay as little rent as possible. There are two kinds of interest rates:

1. Simple interest. Simple interest is nothing more than the interest is a % of the principal borrowed. For example, you borrow $1000 at 10% interest for a year, you pay back $100. It’s simple!

2. Compound interest. Albert Einstein actually said compound interest was the greatest invention of the 20th century! Compound interest is like a series of simple interest contracts, linked together. What you should know is you could PAY interest on interest, or EARN interest on interest. Compound interest can either make you a rich person, or bankrupt you. One thing, though is for certain, you better understand it!

What determines interest rates? There are five primary components. One is the risk free rate, (usually the rate of the U.S Govt T-bill. Add to that a DRP (default risk premium) and an IP (inflation premium), an MRP (maturity risk premium), and LP (liquidity premium) and you have your interest rate. This is why credit card rates are so high, all these premiums are added. Compare that to the U.S. Govt. Treasury bill, and you basically have a risk-free rate and an inflation premium, which leads to a much lower interest rate than a credit card.

Typically, home and car loans are simple interest loans. Credit cards are compound interest, and many of them compound interest DAILY. This means interest builds upon interest each compounding period, and when the credit card contract says “compounded daily”, then you know you are paying “high rent” to use that money. If you think about it, most financial decisions revolve around the time value of money. This includes risk, time, and interest rates. Understanding the present value of future cash flows and the future value of present cash flows is fundamental to understanding the “street smarts” about money in today’s world.

Interest rates are fascinating-and move all the time. You will pay much less interest over time, and save a LOT of money, if you understand interest rates. Remember, most financial decisions revolve around the time value of money. If you learn nothing else about money, learn that cold. The information is out there, it’s up to you to use it !